China and Europe’s economic insecurity suggest the glory days for the convergence trade are over
Are the glory days over for the China convergence trade? The world is in turmoil, investor perceptions are in disarray and cosy notions about Chinese interest rate and bond yield convergence to the United States are open to question. Chinese yield spreads over the US are so wafer thin, further narrowing may be pushing the boundaries of risk-reward credibility. China’s government bonds may be a novel diversification opportunity for investors, but perceptions of “fair-value” might have reached the end of the road and spread divergence may be the next step for investors.
This isn’t good news for China’s renminbi and is a potential problem for an economy still dependent on valuable inflows of funds from abroad to help supplement domestic funding requirements. At a time when China’s domestic credit expansion has been slowing, it’s also not the best news for growth. Global economic uncertainties are rising, leaving China’s economy and currency stability more vulnerable.
What convergence bulls look for most in global markets is robust outperformance. Looking at the state of play in China’s bond and equity markets right now, there is not much to get pumped up about. Interest rate and yield convergence plays look spent, China equity market prospects have faded, thanks to weaker growth prospects, and the outlook for the renminbi is fragile. With financial markets under a cloud, the argument for greater investor caution is strong.
While nothing is cast in stone on convergence trades, investors have important rules of thumb to follow. Generally, yield convergence trades work best when bond markets are in a bull phase, interest rates are in easing mode, the target currency is strong, relative yield appeal is high, global stability risks are low and investor confidence is positive. Right now, the outlook is mixed, with little reason for investors to stick their necks out too far.
While world bond markets have seen lower yields in recent months, with investors fearing the worst for global growth thanks to the US-China trade war, the jury is out on whether the recent bond rally is nothing more than a temporary blip. With US Federal Reserve tightening acting as a buffer to dynamic domestic growth, the longer term trend for US treasury yields is still skewed to the upside – especially if Washington and Beijing manage to patch up their differences over trade. It’s too early to say the Fed’s tightening cycle is over just yet.
The pendulum is swinging towards lower rates in China, but renminbi sentiment remains on a weak footing and general convergence fundamentals seem unsettled. Italian bond market spread behaviour is one of a number of convergence bellwethers, and signs there are not encouraging. Within the past 12 months, the 10-year Italian-German government bond spread has surged from a 115-basis-point low to 290 basis points recently. It’s not just worries about Italy’s poor fiscal record and fragile politics; underlying European and global uncertainties are also taking their toll.
Considering the outlook, there’s not too much for China convergence bulls to look forward to. The 10-year China government bond differential over US treasuries shrank as low as 28 basis points last November, but with the spread currently at 51 basis points, momentum factors are tilting towards greater divergence and more spread widening ahead. Much depends on Beijing’s plans for rebooting the economy.
Given the risk that China’s economic growth prospects underwhelm this year, Beijing is under serious pressure to do much more for future monetary and fiscal stimulus. More monetary easing and the promise of further rate cuts could support China’s debt markets but the renminbi could suffer badly – on balance, neutral for convergence expectations.
The chances are that Beijing will be better disposed towards a bigger fiscal intervention, which means more deficit spending to bump-start growth. The upshot is increasing upwards pressure on government bond yields, pushing China-US convergence trades into reverse and putting the 10-year China-US yield spread on course for a future revisit to a 150- to 200-basis-point range.
With cracks appearing, China-US bond convergence bulls are skating on thin ice.
Source: South China Morning Post